How a $31.45 trillion US fiscal earthquake could shake the world

Washington is ready for a fight over self-imposed national borrowing limit, raising profound questions, again, for the US and globally

As the self-imposed borrowing limit saga looms again, Washington is poised for political brinkmanship with global reach. The question is simple: how long can it borrow, run up debt and print dollars?
Dave Murray
As the self-imposed borrowing limit saga looms again, Washington is poised for political brinkmanship with global reach. The question is simple: how long can it borrow, run up debt and print dollars?

How a $31.45 trillion US fiscal earthquake could shake the world

Another battle over the need to raise the United States' self-imposed government borrowing limit is looming in Washington and over the world financial system.

It has a range of potential consequences, from the impact on key economic indicators and the fight against inflation via interest rate hikes, to questions over the suitability of the dollar as the world’s reserve currency.

Then, there are wider knock-on effects for the world economy, global currencies, banks and listed companies.

If the stand-off does not end in the ceiling being raised – or at least in measures to keep borrowing running to meet certain spending plans and repayment obligations – much of the US government could grind to a halt, and the US could even default on its debt for the first time ever.

Diana Estafana Rubio

Whatever the outcome, the brinkmanship itself raises a question that is both profound and simple: How long can the US borrow, accumulate debt, and print dollars simultaneously?

The US national debt hit the debt ceiling in January 2023 at $31.45 trillion, at a level revised in late 2021, and has since been borrowing on international capital markets via a rolling series of extraordinary measures.

They are now at the centre of the latest round of partisan bickering and bargaining in the US Capitol.

When the ceiling was touched around the start of the year, it took the debt per American to $94,000, or 121% of the country's GDP.

When the ceiling was touched around the start of the year, it took the debt per American to $94,000, or 121% of the country's GDP.

Diana Estafana Rubio

With political opposition from the Republican party to lifting it again, the US in effect faces one of three possibilities: Immediate spending cuts and/or tax hikes; default on paying investors in its government bonds, one of the corner-stone assets of the world financial system; or tackling the ceiling, by suspending, increasing or reviewing it.

Any review could open the way to sustain specific payment programmes and repayment obligations during the process. The ceiling has been raised 78 times since 1960, 49 times under Republican administrations and 29 times under Democratic administrations.

A ceiling in place from 1917

The federal debt ceiling was set for the first time by the Second Liberty Bond Act of 1917.

The US is not the only country to set a ceiling on its government spending; the move has been adopted by another country, Denmark, since 1993 as a constitutional requirement. The EU has set the debt ceiling of member states at 60% of GDP under the Maastricht Treaty's Stability and Growth Pact.

A cap on federal debt is, most of the time, a useful thing for the US Treasury. While it stays within the limit, it does not need to seek approval from Congress for issuing its bonds.  

But when the national debt hits the limit, accommodating the borrowing and spending needs of the nation on an ongoing basis becomes a hot-button political issue amid the threat of a default, with all the risks it poses to global finance, becomes a real, live threat.

When the national debt hits the limit, accommodating the borrowing and spending needs of the nation on an ongoing basis becomes a hot-button political issue amid the threat of a default, with all the risks it poses to global finance, becomes a real, live threat.

That creates significant questions about the usefulness of the ceiling, especially over the regularity with which the problem recurs.

Dave Murray

In the event of reaching the federal debt ceiling and not paying dues to existing bondholders, the US would be in default. There are immediate solutions to cut other forms of government spending to avoid that.

Shutting down and downsizing public spending and services, which can be a sudden measure, is one of the most significant. It happened when 800 government employees were laid off for five days after President Bill Clinton's budget was rejected in 1995.

The most recent was the massive shutdown between 22 December 2018 and 25 January 2019, due to opposition from lawmakers to President Donald Trump's proposed spending increases, most notably to finance the construction of a wall between his country and Mexico.

A clash along party lines between Democrats and Republicans

Political agreement is needed to lift the federal debt ceiling. It requires agreement between the White House and Congress to get signed off.

It is often used as a trigger for a tough talking between Democrats and Republicans who try to score political points and an advantage for themselves as what often turns out to be a hard bargain is struck.

Republican House Speaker Kevin McCarthy said in his electoral campaign that he would stand in the way of giving a blank cheque on government spending: "because the expenses are out of control, and there is no oversight... We need to change the way money is being recklessly spent in this country."

He later compared government spending to a household budget, saying, "If you give your son a credit card and he reaches the maximum authorised withdrawals, do you increase his ability to borrow or ask him to cut spending?"

That was branded as a false analogy by major economists.  Leonard Burman and William G. Gale, of the Brookings Institute pointed out that the debt ceiling has already been approved, and not lifting it would amount to not paying an existing bill.

In his State of the Union address to Congress, President Joe Biden warned against "holding the economy hostage" and added that "the principle of raising the debt ceiling is non-negotiable." He called on McCarthy via Twitter to meet him at the White House and discuss the matter.

"In debt we trust" 

Internally, the consequences of not agreeing to a sufficient increase in the federal debt ceiling before 5 June will be dire, according to the Congressional Budget Office.

At home, the government will lose a key source of day-to-day funding. The motto printed on dollar bills reads "In God we trust". An alternative wording might better reveal how the US is financed: "In debt we trust". 

Without rolling debt facilities, the government would fail to meet its obligations to citizens and millions of people would miss cash payments, especially the retirement cheques of the elderly. Government employees, including soldiers, would also go unpaid.

Without rolling debt facilities, the government would fail to meet its obligations to citizens and millions of people would miss cash payments, especially the retirement cheques of the elderly. Government employees, including soldiers, would also go unpaid.

The wider economic uncertainty will hit sentiment and the markets, not just those in government debt, where confidence would be rocked by any such potential default, which is, as yet,  unprecedented.

The shockwaves would hit stocks and would be enough to put jobs under threat across the real economy. The dollar would face consequences, with some seeing a decline in its exchange rates as inevitable, although the outlook for it is complicated by haven asset demand. The price of gold would be highly likely to jump.

A high-level warning of recession and economic damage

It would all amount to what US Treasury Secretary Janet Yellen has warned would amount to a financial crisis and then a recession, causing deep and difficult-to-repair damage to the US economy.

The government's arrears will also increase the cost of its debt, even in the short term, further complicating the management of the federal debt.

Credit rating downgrade and trouble for holders of US bonds

This is likely to lead to a downgrade of the country's credit rating. This happened in 2011 under President Barack Obama, when the Washington debt ceiling brinkmanship peaked.

The rating agency Standard & Poor's to reduce the country's credit rating from AAA to AA – although Congress eventually agreed to raise the debt ceiling, and there was no default.

Even without a default on US Treasury bonds, questions over the US government's ability to borrow could undermine confidence in US financial assets and the wider investment case in the country, undermining its market credibility.

Global finance would face chaos and uncertainty, given the role of the US dollar as a global reserve currency in the international monetary and financial systems, as well as the role of US Treasury bonds in asset pricing and in the dollar-based liquidity transfer system.

The holders of these bonds will be the first ones to be directly affected, either by late payment or default; they can be divided into two groups.

The first is internal to the US, consisting mainly of private investors – pension funds, insurance companies, and retail investors – and holding 31% of the total bonds, followed by public pension funds  with 22%, the Federal Reserve, and finally American banks.

The second is external – it holds the second largest share of total bonds at 25% – and is composed of foreign states and private investors from abroad.  

Diana Estafana Rubio

The structure of foreign state holdings of US Treasury bonds has undergone significant shifts in the last decade. In 2018, Russia sold off its $100 billion bonds holdings.

Since 2011, China has quietly cut its exposure to US government debt to under $1 trillion. That put Japan at the top of the list of the largest US creditors with nearly $1.13tn, followed by the United Kingdom, Belgium, and Luxembourg.

In the Arab world, Saudi Arabia tops the list of holders of US Treasury debt at $121.1bn – this is the highest holding in the Gulf; it is followed by the United Arab Emirates, Kuwait, Oman, Qatar, and Bahrain.

Outside the Gulf Cooperation Council, Iraq is at the forefront of the Arab countries investing in US Treasury bonds at about $40bn.

In the Arab world, Saudi Arabia tops the list of holders of US Treasury debt at $121.1bn – this is the highest holding in the Gulf; it is followed by the United Arab Emirates, Kuwait, Oman, Qatar, and Bahrain.

How long can US borrowing go on?

The regular recurrence of the debt ceiling issue prompts a wider question, over and above Washington dealmaking over official limits: how long the US can go on borrowing and accumulating debt?

The natural limit – as defined by the global debt market rather than the rulemaking of politicians – seems some way off. US Treasury bonds are currently,  at least in principle, one of the safest investments in the world and there is no risk of collapse in demand in the foreseeable future.

Even if the US ever loses significant borrowing facilities, it will still have the potential to trigger other fiscal levers, such as liquidating public investments and increasing tax revenues, which today amount to 20% of its GDP – a low proportion compared to some European countries, such as Belgium, where it is at almost 43%.

The Federal Reserve could also, in theory, print dollars to meet payments to the holders of government debt. The Fed itself is, in effect,  also one of the biggest holders of Treasury bonds.

The real problem is that the dollar's role as the worlds reserve currency would be undermined by the long-term blow default, or even the repeated threat of it and the impact it has on the investment case over US assets and the level of confidence in them.

The country that is currently the most qualified to challenge the leading monetary and economic position held by the US is China. However, as the second largest creditor of the US it is also exposed to any default on Treasury bonds.

And any rise of China's yuan to status as an alternative to the dollar also depends on a range of factors, not least the attractiveness of Chinese government debt to international investors. The complex picture over European government debt was one of the reasons the euro failed to take off as a rival reserve currency to the dollar, in terms of its use as in global payments and settlements.

"Economic terrorists" and a warning from a Nobel economics laureate

There are those who warn that the current political battle between Democrats and Republicans over raising the federal debt ceiling may not pass off as peacefully as it did in similar stages over the past 30 years.

Professor Paul Krugman, who won the 2008 Nobel Prize in Economics, is a leader in this argument.

Writing for the The New York Times, Krugman said he was worried about far-right groups – they are part of the Freedom Caucus, they control the Republican Party, and they were behind the election of McCarthy as speaker of the House of Representatives. McCarthy made promises to meet the group's goals in reducing many financial expenses, mainly the Obamacare health insurance system. 

Krugman also said he feared that these groups would deliberately obstruct solutions in order to "watch the world burn under a democratic administration." He called for Washington not to submit to "economic terrorists", resisting them via the adoption of temporary special measures to overcome the impasse.

Trillion dollar coin or fiscal earthquake?

Those measures could include a legislative technical measure that attracts a number of rational Republicans to pass the debt ceiling agreement, an exceptional issuance of platinum coin by the government at a nominal value of $1 trillon to be purchased by the Federal Reserve from the Treasury.

Other experts are more unnerved.

Mark Zandi, chief economist at Moody's Analytics, points to a very dark picture if no agreement is reached before the beginning of next June to raise the federal debt ceiling; he believes things will head to "fiscal Armageddon," that is, the end of the financial world as we know it. 

Mark Zandi, chief economist at Moody's Analytics, points to a very dark picture if no agreement is reached before the beginning of next June to raise the federal debt ceiling; he believes things will head to "fiscal Armageddon," that is, the end of the financial world as we know it. 

"Chimerica" and seismic shifts in geopolitics

There is wider talk of a violent fiscal earthquake. While the US debt ceiling is a risk, such a seismic shock to the global financial system may happen anyway in the foreseeable future, with shockwaves that would be felt around the entire world.

It could stem from the collapse of "Chimerica" – a term coined by financial historian Niall Ferguson and economist Moritz Schularick to denote the interdependencies between China – the world's largest creditor – and the US – the world's largest debtor.

Cracks in the Chimerica relationship will deepen if the US defaults on its debt. China would then strengthen its position in the Brics countries of Brazil, Russia India, China and South Africa.

This is especially true after the Russian invasion of Ukraine, the US warnings of any Chinese attack against Taiwan, and the US supply of arms to Russia.

The founding manifesto of the Brics publicly acknowledges the pursuit of a bipolar world order. It is striving to expand and include other groups such as the Union of South American Nations (Unasur) and the Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation (Bimstec).  

The Brics group has recently launched consultations to establish its own system of transfers and payment orders as an alternative to the most-used international standard, called Swift. It has established a monetary reserve fund to protect its members' currencies against global liquidity pressures.

These are the kind of developments that can create the conditions for any Chimerica earthquake. And the aftershocks of that would go way beyond financial, commodity and wider economic markets. Seismic shifts in the global power balance on that scale could cause a full-blown war.

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